Private equity, the high-return-oriented asset class channeling third party capital to companies looking to grow or streamline operations, is a burgeoning business in many emerging markets, and the Middle East and North Africa (MENA) region is no exception. It is an alternative to methods of investment and financing, generating interest among Arab investors willing to invest in their domestic or regional economies and can prove valuable in the medium term. In the past, oil booms providing excessive liquidity to Gulf financiers was spent on projects in North America, Western Europe, and industrialized Asia, fuelling political economy debates.

In a new direction for this asset class, money is flowing within the MENA region rather than leaving it. According to a speech by Gary Long, Investcorp’s President and Chief Operating Officer, in 2002 nearly 85% of the region’s wealth was sent overseas to dollar-backed investments; in 2007 this had dropped to 75%, attributed to attractive opportunities in domestic markets. Investcorp established itself as one of the premier moneymen encouraging MENA capital flows abroad, yet the firm, like other big shots such as The Carlyle Group, is no longer borrowing Gulf money for investments solely in the West, but has started investing in many of the region’s own companies, and channeling Western limited partner capital to companies in ranging in area from Morocco to  South Asia, where a slew of firms are looking for development capital in diverse sectors such as telecoms and consumable goods.

From the family firm to the sovereign wealth fund, Arab investors are heavily considering their role as limited partners and banking on the economic potential of the region to return their money at rates exceeding 20% annually, although potentially reaching highs of 40% for the most undervalued investments and promising exits on regional bourses. The availability of new financing vehicles is making local investors more willing to get involved in places where governments are appearing friendlier to foreign investment and competition. In recent years, Bahrain, Kuwait, Oman, Qatar, and Saudi Arabia have amended foreign ownership laws, permitting up to 100% foreign ownership in firms after receiving approval from in-country regulators. Libya’s regulators have made similar moves with Foreign Investment Law No. 5 of 1997, changing the dynamics of Libyan bureaucracy for businesses.

Virgin networks

Outside capital is also flowing to the region, in search of new markets isolated from woes negatively affecting Western economies. New funds are springing up to match the demand. The Carlyle Group, once known only for its ability to develop MENA-based limited partners in Western markets, established a MENA-centric fund. BNP Paribas also recently announced plans to launch a private equity fund for the MENA region with a fund size of $200-400 million under management. The MENA fund will be the group’s first with a non-European scope and is likely to develop the trend of more Western private equity houses moving to the region.

The key for firms looking to grow operations in the region is networking ability. Both Carlyle and BNP Paribas will doubtlessly rely on their local contacts, managers, and synergies from pre-existing businesses to  source the proper mix of limited partners — including government, private funds and families commanding significant sums of capital. New firms will face tougher entry costs in linking with the right networks and overcoming the unseen barriers of sourcing and financing in the region.

However, as institutions and individuals gain an understanding of private equity and become more interested in investing in their own MENA markets, new firms will have the chance to prove their capabilities, grow their teams, and execute transactions. But the window to enter a nearly-saturated MENA chessboard is small and firms will have to move in the next three to five years before the first round of industry consolidation hits the region, closing down many small boutique operations and leaving behemoths with the proper relationships and track records. Consolidation does not mean demise in the industry or in the region’s opportunity, but only a process of leaving the most efficient operations standing.

Courting regulators

Regulatory relationships will stay important in the medium term as the region faces several regulatory barriers affecting foreign ownership, among them restrictions limiting foreign capital to a minority stake in most deals and other measures with corollary aims of softening capital inflows and dangerous double-digit inflation levels. On paper, changes have been implemented, but the regulatory outlook will only change after further proof of willingness to stamp out capital controls on foreign money.

BNP Paribas likely cemented its fund aspirations after smart maneuvering through the relation-dominated waters of the region. Prior to announcing the fund, BNP Paribas owned 25% of SAIB Asset Management, an arm of the Saudi Investment Bank and likely leveraged relationships in the kingdom to earn an asset management license from the Saudi Arabian Capital Market Authority, as well as current expectations to acquire a 100% investment banking subsidiary license from Saudi authorities.

Turkey is undoubtedly joining the fray of new regulatory outlooks with authorities implementing a new law to make private equity acquisitions of Istanbul-listed firms easier. This boosts buyouts, like the planned $1.55 billion minority buyout of the country’s Migros supermarket chain by BC Partners, a consortium including Turkven, DeA Capital, and the De Agostini group. The news comes after Turkey hosted the largest leveraged buyout of Migros by the Koc group for a 50.8% controlling stake.

The fact that many regional businesses are family affairs might continue to hinder the purity of burgeoning investment vehicles like private equity as long as exit plans remain stalled. For example, Gulf governments, in an effort to ease the worries of family firms looking to retain ownership through the restructuring of the private equity process, decided to regulate some initial public offerings, allowing families to retain 70% of the shares once the firm is on public capital markets. News reports have explained the move was largely wasted because family firms remain recalcitrant to the new regime. According to attendees at an industry conference hosted by Private Equity International, 35% believed family-owned businesses look for value added, operation capability from a private equity firm, 23% believe the prime mover for family firms is private equity capital and 16% believe family firms look for chemistry with private equity shops.

Fund trends

A lot of funds went on market in the first half of 2008, with eight new ones announced. Although Tuninvest’s close of its Maghreb Private Equity Fund II for $121.6 million is Maghreb-specific, the seven others have made notable closes spread across the region, including: Kuwait’s Global Investment House’s $500 million buyout, a $555 million close for the Horus Private Equity Fund III LLP, managed by the Egyptian-based and focused EFG-Hermes Private Equity, Eastgate Capital’s $250 million close for its first fund, and Millennium Private Equity reporting two fund closes aggregating $350 million among its Global Energy Fund and its Telecoms, Media & Technology (TMT) Fund. Paladin Realty Partners also unveiled a $50 million close for its thus-far rather paltry MENA-focused realty fund. The Horus Private Equity Fund III LLP’s $550 million close made it the largest for an Egyptian/North Africa-targeting fund.

In a new MENA frontier, the Levant, SHUAA Partners closed its Frontier Opportunities Fund I, LP with $100 million in capital commitments for Levantine investments targeting Syria, but Jordan and Lebanon as well — three countries outside the scope of the asset class since its formal launch in the region in the late 1990s.

Levantine markets will attract more attention with decreased regulation and political stability, in addition to the large demand for firms looking to fulfill company goals. In private equity, firms once constrained can find capital to finance growth, acquire other firms, or recapitalize existing operations. The asset class will be more competitive than over-bureaucratized banking in markets dominated by large commercial players with high levels of collateral demanded and lending preferences to other behemoths.

New mixes of private equity financing include mezzanine debt, which is attractive for mid-sized companies witnessing strong growth. Service-based industries with soft assets can borrow on a cash-flow basis with mezzanine’s debt and equity structure subordinate to senior bank debt.

Respondents to Deloitte’s MENA Private Equity Confidence Survey ranked development or growth capital as the most popular transaction type in the region, dominating other bars in the chart with a whopping 64%. The figure comes as no surprise when viewed on par with statistics showing the equally popular growth in private companies and enterprises. A trend to grow existing operations rather than fund new ideas is the prime driver of Middle Eastern private equity, although the paltry level of venture capital is anticipated to grow. Growth capital works in tandem with a private equity house’s value-creation operation, whereby experts tweak business procedures by implementing a series of best practices aimed at building the attractiveness and financial book strength of the firm for its initial public offering or the secondary market, where other asset managers can continue adding value, once started by a first private equity house. Two percent of respondents to Deloitte’s survey believe secondaries are going to be the most important type of private equity.

The MENA’s private equity landscape carries with it a mood of optimism, claiming no end to investment capital and deal flow. However, performance has yet to be realized for most funds. Those with closes are still not fully invested and those with investments have been hanging on to their companies postponing exits. Investments will have to pick up as fundraising figures increase year-on-year.

Zurich-based Bank Sarasin has roughly $80 billion in assets and saw share prices rise almost 20% last year. With branches already in Bahrain, Dubai and Qatar, it will likely open a representative office in Beirut within two years. Executive interviewed Burkhard Varnholt, Sarasin’s Chief Investment Officer, about his bank, the political situation in Lebanon and the regional economy.

E What does Bank Sarasin offer current and potential clients in the region?

Our bank offers dedicated client wealth management services and asset management for private and institutional investors. We have no integrated banking model because we feel it strengthens our franchise as there is no conflict of interest. We one-sidedly look after our client’s assets. We do no brokerage, no securities underwriting, no private equity, no corporate advisory or any other kinds of business often combined with private banking.

E Why is Sarasin thinking about opening an office in Lebanon?

We have shared visions and principles in the way we look at the world and investments. Lebanon has a very old and rich culture of economic heritage. So does our bank, which has been around for a good 160 years. When you bring that cultural heritage to the table, it results in a similar way of looking at the importance of preserving assets across generations. Lebanon being a small country and economy with a large diaspora around the world is obviously much more open, not only in its economy, but also in its society. This is a similarity that we share; Switzerland is also a small but open economy. It changes the way you look at the world and the global economy, it forces you to be more open-minded and more international in your aspirations.

E What affect does the current political and economic situation have on your plan to open an office here in Lebanon?

The political stalemate is one thing, but it is telling that the Lebanese economy, after those various external shocks of 2005, 2006 and this year, has always found its feet. And even this year it is likely to grow at 1.5-3%, which is well below its potential, but is still more than many countries in Western Europe or even the United States. If you look at the Lebanese banking sector, for decades it has been exceptionally strong. The government has always been able to maneuver itself through what in other parts of the world are considered unwieldy positions, with debt-to-GDP ratios far in excess of 160%. It speaks to the strength of the underlying real Lebanese economy and how well it is connected, not only in this part of the world but globally.

E How did Sarasin avoid the impact of the subprime crisis? And what do you look for when analyzing potential investments?

We are very old-fashioned investors. We prefer to buy and hold securities that we understand rather than invest in structured products that we sometimes have to admit we do not understand. This is what allowed us to dodge that bullet. We simply did not understand the structures well enough to invest in them.

E That is saying a lot for someone with a PhD in Economics.

When you see triple-A rated securities promising on average 1% higher returns than government paper and you don’t understand the structure, my intuition would be “Don’t invest. Something has to give.”

E Does this speak to a problem with the rating agencies?

Absolutely. Their business model is built upon credibility. Rating agencies’ capital is entirely the credibility that they have built with investors and that has taken a big beating. It will take more than just a few years to repair that.

E Sarasin’s Chief Executive, Joachim Straehle, suggested that subprime crisis losses would likely reach $400 billion. One hundred twenty billion have been accounted for already. Where might the rest of the losses come from?

That number probably comes from adding up all those securities and then taking a discount factor, a conservative discount factor. If you do that you come up with a number of $400 billion, but it could be $200 billion or it could be more. Nobody really knows. The market could stabilize to where investors would stop selling and hold the paper up until maturity. And if that was the case prices would not continue to decline. The trouble is, it only takes one market participant to try to sell those positions and the rest of the market will have to adjust. So it is a very fragile and delicate equilibrium, which can take different paths from here.

E Switzerland’s leading economic indicators fell to the lowest level in five years in June 2008. How is Sarasin dealing with this and where are they looking next?

I think it was to be expected. The United States leads in many things — they led in the financial market crisis, they led the world into recessionary territory. So, much of the time Europe follows the US and now they are following on the path into economic stagnation. They will also follow on the path to somewhat higher inflation. But this is only natural and has happened consistently in post-war history.

I do take some comfort in the fact that the most recent negative economic indicators from the US were lagging indicators. When you see unemployment go up, you should not be concerned because unemployment always comes last in any economic slowdown or upswing. You should be concerned about the leading indicators and it could be that the US economy has seen the worst for this year and is finding a bottom at this point, whereas unemployment will naturally catch up toward the end of the year.

What is critical to this whole development is the inflation scare, which has really been muting financial markets and investor’s risk appetite. I am not so concerned about oil prices at $140 or $150. What is more damaging is the momentum of oil prices. When oil prices double in less than 12 months, it is not good for investor sentiment. I believe we are more likely to see oil prices at $180 than at $140. So if anything, oil prices will go another $40 higher. That does not necessarily mean that it is the end of the world economy. At some point, moving on towards another $40 higher, people will finally be convinced that high oil prices are real. By that time we will be seeing very strong substitution effects, mostly from increases in fuel efficiency.

Beyond that, the world economy remains in better shape than the current investor sentiment suggests. I take comfort, not so much from any recent batch of statistics, but rather from a firm belief that markets are currently underestimating one of the oldest drivers of any economy: human ingenuity and creativity, the ability to innovate our way out of any crisis. Scientific and technological progress will accelerate dramatically over the next decade and mainly for the better, largely to make the world less fossil fuel and commodity dependent than it is today.

E It sounds as if you do not agree with the commonly espoused theory that speculators are pushing up oil prices.

I think that notion is nonsensical. I have looked at both anecdotal evidence and publicly available statistics about institutional investors’ asset allocation and they all tell me that most institutional investors are bearish on oil prices rather than bullish. They expect prices to correct after the recent parabolic increase, rather than to overshoot. One thing that’s so dangerous with bull markets, like this current oil bull market, is that they tend to surprise investors by lasting longer and leading higher than people think is possible. I look at financial speculators among those and I can’t make sense of the assertion that financial speculators are driving it. I think it is something much more fundamental.

Spare daily available production has declined from about three million barrels a day three years ago to less than a million barrels a day, excluding heavy, high sulfur product. That is very little. If the Middle East sees another heat wave, like it did last year, they would siphon off probably a million barrels a day to power their air conditioning. Gulf states cannot live without air-conditioning. In today’s environment, siphoning off a million barrels a day is not possible because that exceeds global spare capacity. It did not exceed global spare capacity last year. There are many other scenarios like this and investors are complacent about these risks. If they do happen, we will likely see contagious behavior such as cues at gas stations just as we saw under President Carter in the United States and that will be the last leg of this oil bull market.

E Does this relate to other commodities that have seen exceptionally high prices?

Yes, they are all related. Whether you talk about oil, water or food, it is really all the same. The global food crisis is really a crisis about water. The world, of course, does not have too little water — the problem is that 98% of it is too salty so we can’t use it. Three quarters of all fresh water goes to agriculture. It is really the increasing desertification of formally arable land, which is causing the food crisis. If you want to solve this, you have to desalinate water. However, more than 50% of the operating cost of a desalination plant is energy.

That just illustrates how food, water and energy really are three sides of the same problem. I think the next big resource scarcity will be water. We have come to the end of cheap water. Water is vastly underpriced in virtually every rich economy because it is administered by public utilities. It has never been priced properly. The only place where it is expensive is in slums where the poorest pay the most for it. One of the greatest investment booms, where investors will continue to do spectacularly well is by investing in the entire infrastructure around food, water and energy. It is the world’s biggest boom for the next couple of years.

E How is all of this related to the developing world and your Global Village fund?

If you look at the four BRIC countries — Brazil, Russia, India and China — together they will contribute four times as much incremental consumer demand over the next five years as the G8 combined. That number in itself says so much about the change in global economic order and it is here to stay.

The Global Village fund tries to capitalize on some of our strongest convictions, which we have held for many years. The world economic order is changing faster than many people would ever have thought possible. Investors can no longer apply the 1980s asset allocation model of allocating funds according to regions or statistics that are biased towards developed economies, simply because they never bothered with emerging economies. It is about the strong belief that in an increasingly interconnected world, which looks more and more like a village than one fragmented by nation states, investors are well advised to take thematic investment tilts, such as the food energy and water theme, which cut across countries.

The first decade of the 21st century will be remembered for its soaring inflation, with TV images from around the globe of people queuing for bread or demonstrating violently against high food prices. In the MENA region, inflation originates from both external and internal factors. While external factors are similar across the region — and essentially imported from the West — internal factors vary between oil producing and non-oil producing nations.

Economists agree that the weak dollar is one of the main reasons fueling MENA inflation; its effect, however, varies from one country to another.

Lebanon’s heavily dollarized economy is obviously adversely affected by the ailing greenback, but its neighbor Jordan is suffering as well. According to Dr. Rasha Manna, head of research at Jordinvest, the Jordanian dinar’s dollar peg and the rising exchange rates have reflected on the country’s debt, estimated at about 70% of GDP. “We have been significantly affected by the weakening dollar due to our particular debt structure of which 30% remains in dollars while, the rest is comprised of various international currencies. Our debt burden is estimated to have increased by 4% in 2007 due to the depreciation of the dollar against the euro,”she said. The current debt structure in Jordan is primarily divided up into Euro (up to 23%),Yen (18%), and the Kuwaiti dinar (14%), with the latter appreciating since Kuwait abandoned its dollar peg. Approximately 10% of Jordan’s debt is held in British pounds.

With the Hashemite currency’s peg to the weak dollar, imports to Jordan are becoming more expensive. Only 5% of Jordan’s imports originate in the US. And while dollar-denominated imports by far exceed this figure — one has to add the 20% of imports made up by oil — the 30% of imports which come from the EU and 40% from Japan are burning holes into the kingdom’s bourses.

In the UAE, SHUAA’s chief economist and strategist Dr. Mahdi Mattar estimates inflation from imports may account for 3% of the total 11% national inflation level.

Among other external factors contributing to inflation are higher commodity prices, especially food. Many countries in the region rely on imports of essential food items such as wheat, rice or sugar. “The demand for food is certainly fueled by the growing needs of large economies such as India and China,” underlined Dr. Louis Hobeika, professor of economics at the American University in Beirut. The high Euro is partly to blame for high inflation in Lebanon, which imports many of its products from Europe. “Lebanese traders have also been used to work for decades with European countries, and it is somewhat difficult for them to adjust their purchasing behavior as they also tend to feel that US products are not much cheaper when transport expenses are taken into consideration,” he adds. This state of affair equally reflects on the UAE markets, where growth in global prices has risen considerably, according to Mattar.

Fuel for rising costs

In Egypt, inflation is taking a cost-push form that relies mostly on internal factors, such as decreasing government subsidies, according to economist Dr. Heba Nasser, Vice President of Cairo University.

Oil prices, which have reached unprecedented levels of $140 a barrel, have strained economies around the world. The MENA region has been affected differently by higher oil prices, as many countries throughout the region boast large natural reserves of ‘black gold’. “Oil producing countries also experience inflation, but high energy prices allow them to subsidize their industries heavily and offset any potential negative effect of the trend, which is therefore less felt by the population,” said Hobeika, who estimates the contribution of oil to price increases in Lebanon to at least 25% of total inflation levels.

The lifting of fuel subsidies in Jordan has been absorbed with difficulty. “The government had been progressively phasing out oil subsidies for some time, before it abolished them completely in February 2008,” Manna reckoned. A recent study by the Jordanian Ministry of Industry and Trade found that fuel prices accounted for only 10% of total production cost in about 90% of Jordanian plants. This figure varies evidently from one industry to another, a typical counter example being cement industries where 40% of expenses can be attributed to oil.

On the local level, internal factors ingrained in the economy are also conducive to higher inflation levels. Hobeika believes that Lebanon’s monopolistic economy weighs heavily on its current health. “Exclusive agencies, which restrict imports of certain brands to a few players, are something of a common sight in our country and consequently hike up inflation,” he underlined, while also pointing out that Lebanon needs to cancel exclusivity contracts in order to join the WTO.

Towering real estate

In the UAE and Jordan, elevated real estate prices have projected inflation to new levels. “The supply bottleneck witnessed in the UAE is one of the main contributors to high inflation,” said Mattar. He said within 18 months, the Dubai real estate sector will stabilize at new levels as new real estate projects are placed on the market for sale, while in Abu Dhabi the supply of residential and office spaces will grow tremendously by 2010. However, he added “the rent caps imposed by the UAE government might be detrimental to the real estate sector as it might discourage or slow investments on the long run.”

In Jordan, housing prices have also increased significantly, growing by some 300% over the past two to three years. The introduction in 2010 of a new rental law will allow for new contracts to undergo yearly appraisals, which will also further exacerbate inflation, of which housing expenses account for about 26%. Dr. Sabra acknowledged that the price of land and real estate development has definitely fueled inflationary trends in Egypt, where official figures reached 12.5 % in May 2008. “Our situation is somehow comparable to Jordan, the only major difference residing in the fact that our wages are much lower than in the Hashemite kingdom,” she added.

Mattar emphasized that high oil prices have certainly generated unprecedented wealth and an excess of liquidity and placed inflationary pressures on Gulf economies.

So how can regional countries cure inflation? Hobeika believes that the global nature of inflation renders the problem quite difficult to solve in light of external factors, which have a trickle-down effect on local economies. “We are faced with two choices on the global level, either increasing supply or lowering demand in sectors contributing to price spikes,” the Lebanese economist admitted. When this is applied to the oil market, increasing supply beyond a certain level may be a daunting, if not impossible, task for oil-producing countries. On the other hand, lowering demand by investing in new technologies might be a viable solution. “One has to keep in mind that if the world economy was in better shape, instead of being plagued down by successive crises — such as the subprime and the more recent Freddie Mac and Fannie Mae debacles — the price of oil would have certainly reached higher levels,” Hobeika said.

When it comes to food shortages, Hobeika believes that much can be done in this regard with the possibility of doubling production levels through improving management of agricultural land and proper irrigation, dovetailed with a sound development of rural areas. “Demand for food items can’t be realistically expected to drop and the new billionaires of this world should maybe start investing in the agro-industrial sector,” he added. He also estimated that raising wages without increasing productivity will only contribute further to inflation.

On the national level, each country in the region has different weapons at its disposal to combat inflation. In Lebanon among the solutions envisioned are moving away from the dollar peg and liberalizing the sector by issuing new regulations and removing exclusive agencies. Encouraging people to invest in Lebanon would allow to increase productivity and reduce the long-term impact of inflation by improving growth levels, and it can be accomplished by improving the political environment and privatizing the economy. “While dollarization was used in the eighties as a powerful tool to master inflation, now it undoubtedly contributes to it. In the next few years, we should maybe envision a system based on a flexible exchange rate. But this, however, needs to be underlined by a restrictive fiscal policy,” said Hobeika. 

Measures adopted by the Jordanian government include decreasing interest rates by less than what the U.S. Federal Reserve recommends. “Local interest rates were lowered by 75 basis points instead of the 325 basis points that is imposed in the USA,” Manna explained. She identified other measures, such as increasing foreign currency reserves, which also, in her opinion, need to be more diversified, as well as controlling fiscal spending. She pointed out that, “An appraisal of the dinar against the dollar could be also feasible. However, lowering inflation without slowing growth is a tricky problem.”

For Mattar, inflation in the UAE could be fought by increasing reserve requirements in order to reduce the national money supply. “This has been already implemented by the government in Saudi Arabia that has moved up reserve requirements of banks from 7% to 9%, and then from 9% to 12 % again last April, after they had remained unchanged for over 23 years,” he added. The UAE has also tackled the international food crisis by buying farms in Pakistan, although such measures aim essentially at securing sources of food and do not actually fight inflation, according to Mattar. He estimated that in order to reign in inflation the UAE will eventually also need to move away from the dollar peg.

Nasser said Egypt needs to encourage industry to increase productivity to fight inflation. Such encouragement must be done while simultaneously attempting to curb demand by modifying people’s purchasing behavior; this effort is currently being undertaken by the local media as well as NGOs. “This effort, when dovetailed with the establishment of a consumer protection authority, can be efficient on the long run,” she noted.